The cost of stock options

April 06, 2004

The Financial Accounting Standards Board, which sets rules for U.S. accountants, is likely to require that companies begin counting the stock options they give employees as a business expense. You may not care deeply, but be assured that many American firms do.

A primer: Stock options give the holder the right to buy shares of a stock at a fixed price over a set period of time--say, 10 years. If a company's stock price rises over time, the options can be worth a bundle to the holder who cashes them in; if the stock price falls, they're worthless. Companies that give their executives or other employees options must disclose that compensation in footnotes to their financial statements. But, in part because nobody knows the ultimate cost of stock options when they're granted--remember, that depends on stock prices in the unknowable future--firms needn't count them, like wages, as current business expenses. Requiring companies to calculate options as current expenses will erase billions of dollars from their profits.

This controversial proposal has been coming for a couple of years. FASB is withholding final judgment until summer, but it's pretty much a done deal. Federal Reserve Board Chairman Alan Greenspan and the Securities and Exchange Commission support expensing, hundreds of publicly traded U.S. companies are already doing it, and the International Accounting Standards Board has approved the expensing of stock options beginning in 2005.

The debate over expensing makes sense if you understand that stock options were one cause of the whole, sorry saga of greed that drove the stock market boom of the 1990s, the ensuing bust, and the corporate financial scandals that followed. By paying employees in options rather than cold cash, some companies in effect disguised their full costs of doing business.

Requiring options to count as expenses will, in the eyes of reformers, prevent that from happening again. So why the controversy?

- Expensing would raise the cost side of corporate balance sheets. For some high-tech startups, it would eliminate profits altogether. That could crimp innovation and job creation, and leave startups with two distasteful choices: Either they have to find some other carrot to persuade people to work for them (since they don't have cash to pay lucrative salaries). Or they'll have a harder time raising capital because of their lack of profits. If option expensing were already mandatory, earnings of all companies in the S&P 500 stock index would have been about 8 percent lower last year. But earnings of the 100 largest companies in the technology-heavy Nasdaq index would have dropped 44 percent.

- There also is no consensus on how stock options should be valued. Yes, there are mathematical models for estimating the cost of options granted today, but those models all amount to calculated bets on future stock prices.

FASB believes options should be treated the same as the salary and the health, pension and other benefits XYZ Co. pays Jane Doe. But they aren't the same. Giving Jane the right to buy 1,000 shares of XYZ at $20 a share will cost the company nothing if the stock never rises above $20. Supporters of expensing argue that both XYZ and Jane are surely working to make the stock price rise. So those options likely cost something, and ought to be reflected on XYZ's balance sheet. Opponents say the information is already available for investors who care about it.

Expensing probably will become the rule of the land. But it isn't a panacea for investors and carries a cost that could hurt entrepreneurship. The boom produced corporate scandals because some corporate bosses turned out to be crooks. Few investors were hoodwinked by the fact that stock options weren't on balance sheets.